Endogenous Defaults in the Business Cycle

Abstract

We developed a new-Keynesian DSGE model with heterogeneous agents and an active interbank market, characterized by an endogenous default probability. Banks are heterogeneous in the sense that they face, each period, different liquidity shocks and may or not be constrained in the total amount of credit that they can extend to the private sector. Banks can invest in loans to firms, risk less assets or lend one another. The key feature of the analysis is that the probability of default of banks evolves endogenously and is explicitly taken into account by other banks in their investment decisions. In each period, only a fraction, or even none, of banks’ surplus funds is invested on loans to other financial institutions. If the probability of default is high enough, they shift their portfolio choices to risk-less assets and the interbank market freezes. This affects the total supply of credit to firms and, through it, the total level of investments, output and employment. Abstract The model is than estimated using the Bayes technique and several test are carried on to verify the robustness of the estimation. Our findings show that indeed the default probability plays a crucial role in the decision of banks directly affects the economy; in addition we show how the stability of the financial market affects the the real economy and is connected with real and financial variables. In times of financial turmoil, banks reduce their exposure towards other financial institution, reducing the total supply of loans to the private sector and worsening the crisis. In this context, standard inflation targeting, that seems adequate as a response to standard shocks, is not sufficient to counterbalance negative shocks and may even have a negative effect on the economy, leaving room for unconventional tools. In addition, following real shocks, we have identified an additional channel of transmission of monetary policy, through the resiliance of banks